VeriFone's (PAY) CEO Paul Galant on Q2 2014 Results - Earnings Call Transcript

Jun. 5.14 | About: VeriFone Systems, (PAY)

VeriFone Systems, Inc. (NYSE:PAY)

Q2 2014 Results Earnings Conference Call

June 5, 2014 4:30 PM ET

Executives

Doug Reed, Senior Vice President of Treasury and Investor Relations

Paul Galant - Chief Executive Officer

Marc Rothman - Chief Financial Officer

Analysts

Tien-tsin Huang - JP Morgan

Jason Kupferberg - Jefferies

Gil Luria - Wedbush Securities

Bryan Keane - Deutsche Bank

Phil Stiller - Citi

Dain Haukos - Piper Jaffray

Andrew Jeffrey - SunTrust

Operator

Good day, ladies and gentlemen. And welcome to the Second Quarter 2014 VeriFone Systems Earnings Conference Call. My name is [Tunisia] (ph), and I'll be operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions)

As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Doug Reed, Senior Vice President of Treasury and Investor Relations at VeriFone. Please proceed.

Doug Reed

Thank you, [Tunisia] (ph). And welcome everyone to the VeriFone financial results conference call for the second quarter of fiscal year 2014. With me today in San Jose, California is our CEO, Paul Galant; and our CFO, Marc Rothman.

Today's call is being webcast with both audio and slides available via the link in the Investor Relations area of our website, ir.verifone.com and a recording will be available on our website until June 12, 2014. We encourage those on the phone to access the webcast in addition to dialing in because the slides can be helpful.

First, for the legalities, VeriFone desires to take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Certain forward-looking statements in this conference call, including management's view of future events and financial performance, are subject to various factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements.

For a description of these factors, I refer you to our filings with the Securities and Exchange Commission. Any forward-looking statements speak only as of today, and VeriFone is under no obligation to update these statements to reflect future events or circumstances. In addition, today's call will cover certain non-GAAP financial measures on both historical and forecast bases.

Our management uses these measures to evaluate our operating performance and to compare our results to those of prior periods, as well as to those of peer companies. Please note that VeriFone expects to continue to incur types of income and expense items that are excluded from the non-GAAP results discussed today.

These non-GAAP measures are not substitutes for disclosures made in accordance with GAAP. Reconciliations of these measures to the most comparable GAAP measures are presented in our earnings release, which is available on our website.

Please note that, on today's call, we will refer to the non-GAAP measures, including revenues, gross margins, operating expenses, net income, free cash flow and earnings per share.

During management’s presentation your line will be in listen-only mode, at the conclusion of the presentation, there will be a question-and-answer session. Instructions on how to signal for a question will be given by the moderator at that time. If you do ask a question, please limit yourself to one follow-up question.

Now, I would like to turn the call over to Paul Galant, CEO of VeriFone.

Paul Galant

Thank you, Doug, and good afternoon, everyone, and thank you again for joining us today. Last quarter, I’ve outlined for you VeriFone’s vision and our commitment to become our clients most trusted, most secure and most innovative global partner by delivering the best terminals, payment-as-a-service and commerce enablement solutions.

I also discussed our work to fix our foundation and the work we're doing to turn VeriFone into the company that we want to be, a company that is defined by five pillars. Number one, client first, two, operationally excellent, three, strategically focused, four, properly organized and five, operating with a single distinct culture.

Today I will walk you through the progress we have made on each of these five pillars and we will review in detail the execution against our top three global transformation initiatives that are critical for fixing our foundation and supporting our drive towards our second pillar, which is operational excellence. We believe this work is already producing meaningful results to our clients, our shareholders and our partners.

Quarter-by-quarter we are making progress on becoming one VeriFone. As work to fix our foundation is well underway, we are now starting to draft our next chapter strategy to deliver growth.

This strategy is aimed at helping our clients to drive new revenue by leveraging our payment-as-a-service and commerce enablement solutions as a core expansion of our ubiquitous and secure terminals.

And while we work to transform VeriFone, we continue to win new client business and find ourselves increasingly at the whiteboard with our clients as they develop their growth plans.

I'm proud of the team here, who are not only working hard on defining our future, but also have increase their focus on our clients today, which has again allowed us to exceed our financial guidance, the revenue and earnings per share as well as free cash flow.

So let me now peel the onion a bit on execution against our first pillar in becoming the company we want to be. To us becoming client first means being our clients most trusted, most secured and most innovative partner. And the company they called first when they have a challenge, they need one opportunity.

I have now spent the past eight months traveling the globe to meet with many of our clients, to build the deeper understanding of their perspective on VeriFone. And I’ve done this because we all believe the voice of the clients is critical and central to very business decisions we make here at VeriFone.

Based on our client’s feedback, it became clear to us that putting a relationship management model in place, where we have a senior season professional assigned full time to our largest and most complex global clients would make it fundamentally easier for those clients to work with us. To that end, we have created a team of relationship managers who are advocates for the partnership we seek to have with our clients.

This investment in this group will allow us to do more business with the clients we already serve today and capture additional wallet share. We’re working to fill these roles internally from the ranks of our trusted, most experienced colleagues. So far we have assigned relationship managers to our top 15 clients. Our goal is to have relationship managers working with 20 clients by the end of the year.

I will do a deep dive on our second pillar, becoming a company that is operationally excellent. So let me come back to that because I do want to spend a lot of time on it. And in focusing on operational excellence, I want to talk to you about our top three transformation initiatives which support this pillar.

But again, before we get to that, let’s talk about our third pillar. That’s being strategically focused. With the clear articulated next chapter growth strategy focused on payment as a service and commerce enablement client solutions. As we have discussed at a high level, our strategy is to connector our terminals into our industrial strength, secure payment-as-a-service platform capable of hosting VeriFone as well as third-party developed commerce enablement applications.

Think of this like a VeriFone hosted app store for merchants. We’re building a platform where merchants can quickly download and deploy payment and commerce applications to capitalize on new opportunities to capture additional revenue and grow their relationships with their end consumers.

We intend to fund these investments with the cost savings we’re generating from our operations and productivity initiatives. I look forward to updating you about the details of our next chapter strategy on upcoming calls.

The third pillar is to be a company that is properly organized with a streamlined organizational structure built around three global product businesses. First, our terminal solutions business; second, our payment-as-a-service business; and third, our commerce enablement business. And we’re making good progress in defining these three organizations. These three businesses are each building their respective global teams and are actively involved in shaping VeriFone’s next chapter strategy.

I am also pleased to report that we continue to strengthen our leadership team with the addition of June Yee Felix, who will serve as President of our Europe region. June joined VeriFone on May 26th and comes to us with the track record of building and operating successful large-scale businesses at Citi, JPMorgan, and IBM. June is based in London.

Next I'd like to discuss building a single distinct culture at VeriFone. As I visit our offices around the world, it is clear to me that there are many elements of our culture today that we all hold in common. These include a very strong client orientation, entrepreneurialism and a commitment to excellence.

One change that we’re trying to make to our culture is a greater sense of accountability and clarity of roles and responsibilities. Our VeriFone scorecards play an important role in this. Last quarter, we ticked off this scorecard process with my direct reports, each of whom is now cascading this deeper into our company.

Today a total of 50 including all my management committee members and a significant number of senior managers are operating with scorecards. Our goal for 2015 is to have this rolled out and operationalized with our top 200 executives.

Let’s now turn back to our second pillar, being an operationally excellent company. Our focus here is to create a globally optimized operating model fixed to needs of our clients. We believe we can achieve this in large part by executing our top three global transformation initiatives. Those being one, portfolio -- product portfolio management; two, R&D reengineering and three, cost optimization.

Let me start by saying that we expect these three initiatives to create a minimum of $35 million in annual run rate savings by the end of calendar year 2014. As I mentioned earlier, we intend to reinvest most of these savings in new growth areas in our three core product lines where we believe we can achieve significant returns on investment.

In product portfolio management which is our first of the three initiatives, we’re starting to process of removing from the market the legacy product that no longer best serve our clients’ needs. Last quarter I told you that we had completed the vetting process for VeriFone more than 1000 product family SKUs.

This is a process that must be done very carefully as you can well imagine in order to meet our commitments to our clients, many of whom rely on being able to buy the same product from us for many years. As of today, we are well underway reducing our product SKUs from over a thousand to less than 500 by the end of this calendar year.

This includes successfully transitioning clients off of legacy, PCI 1.3 products that were sunset beginning on the PCI mandated day of April 30, 2014. Reducing the number of legacy SKUs in the market allows us to focus more of our development capacity and innovation on building the next generation of market-leading VeriFone products.

In keeping with our strategy, these global products are on the leading edge of payments, technology, security, design and capability. They cover the range of market needs and price points and above all our market set in to facilitate our growing payment-as-a-service and commerce enablement businesses.

We will unveil these important new products on a regular basis over the course of the next 18 months. Building these new products of course requires us to continue execution of our second transformation initiative that being R&D reengineering.

I described last quarter our existing R&D footprint consisted of 1800 R&D employees across 75 individual sites globally, supporting 13 core terminal operating platforms and several more platforms for our non-terminal products.

We know this is far from ideal and likely unsustainable. It impacts our efficiency and we’re in the process of finalizing our plans to co-locate our engineering talent in global centers of excellence, placing them in a same room to drive collaboration and innovation and focus them on fewer core platforms.

We have already identified 10 R&D sites, from which we will be relocating staff to these global centers of excellence by the end of the year. And this is just the start. As we make progress on reducing operating systems and hardware platforms, we will have further opportunities to consolidate our R&D footprint.

Additionally, our R&D organization is of course already hard at work, developing the next-generation platform for future products. Unlike the 13th platforms of our current product portfolio, our new terminals are based on a unified hardware and software platform. Our next-generation hardware will come with faster processors, larger memory and leading-edge security capabilities, which will enable our products to have best-in-class levels of functionality.

Our modular extensible and reusable software platform will facilitate both VeriFone, as well as our partners to quickly innovate and provide better end-to-end solutions to our end clients to merchants. So what does this really mean? Well, at the end of the day for our clients it means higher quality, more state-of-the-art terminals for not only accepting card swipes and PIN codes, but also to build and run commerce enablement applications that help them bring in new revenues.

Our next-generation terminals and operating system will help drive incremental commerce across physical, mobile and online channels with instant reward redemption, royalty programs, couponing and targeted offer programs to name just a few. We are hard at work developing a comprehensive migration plan to affect a seamless transition for our clients who wish to leverage these expanded capabilities.

These platform development efforts represent major investments and you will be pleased to know that they are already well underway. We now have test products running in our labs and we expect our first product using this new robust global VeriFone platform to be released to clients in production by the end of next fiscal year. Our objective over the next few years is to move all of VeriFone core terminal products onto this one platform.

Our third initiative is cost optimization. This initiative provides much of the fuel we need to fund our transformation and execute our next chapter strategy. We are continuing the difficult task of looking at every aspect of our business to identify opportunities, to reduce overlap in efficiencies and currently, we have a pipeline of over 100 cost savings projects which we are working to execute.

As a result of this work, we have made the decision to reduce our headcount by approximately 500 people by year end, from 5,800 at the beginning of this calendar year. This decision was difficult but necessary. And we began executing during Q2, reducing our headcount by approximately 150 people thus far. As our transformation progresses, these actions are necessary and will create savings, with a significant portion to be reinvested in strategic initiatives over the next 12 months.

While such decisions are always difficult to make, we really sweated every single one. We believe that this is in the long-term interest of our company, as it will increase our speed to market our operating efficiency and most of all our competitiveness. We are making progress in other areas of cost optimization well beyond headcount as well and are hard at work, redesigning our shared services model for our back office functions.

We expect to close 10 of our 129 facilities, liquidate 19 of our 132 legal entities and consolidate 20% of our datacenters, all by the end of calendar year 2014. There is more work to do and we will continue to make VeriFone more efficient well beyond the targets that I've described for you through the end of 2014.

As you can see, there is a disciplined and data-driven effort underway to transform VeriFone and we are beginning to go from PowerPoint to actual on the ground execution with clients. And we are making tangible progress in the plans that we have laid out for you. At the same time, we are continuing to win exciting new client engagements.

Let me cover a few of those. In our terminal solutions business, we are continuing to see an increased sense of urgency among large U.S. retailers and merchants to accelerate a technology refresh in advance of any EMV related liability shift dates. In the quarter, 15 existing VeriFone clients selected our MX900 series, EMV capable platform as Veri next-generation payment system. And we began rollout at CVS and Kohl's.

Additionally, we want another six clients from our competitors and gain three new U.S. clients that adopted consumer facing payment systems for the first time in order to prepare for EMV acceptance. Our clients know that when they buy VeriFone, they get more than advised.

Our team includes some of the leading security experts in the industry who are at the whiteboard with our clients, discussing holistic approaches to protect consumers’ data and our client’s brands and reputations. We’ve also made some important senior hires to supplement our thought leadership and security.

I'm pleased to report that we've hired Joe Majka to be our Chief Security Officer, to lead VeriFone’s Global Security Operations. Joe has more than 30 years of experience managing security, fraud, cyber security and data breach incident response, including other way leading Visa’s electronic payment data security team.

Additionally, we’ve added Rob McMillan as our Global Head of Product Management for our security solutions. Rob has spent nearly two decades in information security product leadership, including as a leader in RSA where he helped introduce tokenization as a component of payment transaction security. Rob will be working closely with our regional teams and clients to drive commercial innovation and deliver new VeriFone solutions to build on our promise of multilayered approach to security.

Demand for our secure, integrated mobile point-of-sale solutions continues to grow as well. In the second quarter six retailers, including Nike, Godiva, Abercrombie & Fitch and PetSmart agreed to implement EMV capable mobile solutions that integrate with some of the latest Apple devices.

Also in Q2, we launched the portable VX 690, the first of several new EMV capable devices to be built using our near design methodology that leverages an attractive consumer-based design and enables merchants to leverage NFC, low-energy Bluetooth, and many more additional mobile point-of-sale bandwidths. This new terminal will first be available in Australia, where we continue to see better-than-anticipated demand for our terminals through our partnership with several of Australia's leading banks.

Finally in Spain, we continued to strengthen our partnership and expand our business with Redsys, Spain’s largest processor. In our payment-as-a-service business, we are continuing to invest in rollouts in select new markets.

In Q2, we signed the payment-as-a-service agreement with Turkish Airlines that includes a combination of our new secure payment devices, software, helpdesk, field services, and secure IT infrastructure in a subscription-based model. The Airline will roll this out across its 250 owned and thousands of agent branches.

In Australia/New Zealand the work to enable payment-as-a-service continues with two substantial projects well underway with our bank clients and both are expected to go live in fiscal year 2015. In the U.S. the rollout of payment-as-a-service continues with wins at the 250-store sandwich chain, which and several large independent software vendors, who are instrumental in the process of penetrating mid-market merchants and retailers. And in Sweden, happy to report we signed agreements with two new Tier 1 retailers.

All in all, we are seeing exciting traction from this payment-as-a-service business model that we believe offers great security and value to our clients and opens up new growth avenues for VeriFone. We are actively working to expand VeriFone’s payment-as-a-service offering to new countries and we will be reporting our progress on upcoming quarterly earnings calls.

And finally, I want to give you an update on commerce enablement. Last quarter I told you about how commerce enablement business will drive activities beyond payment creating more valuable experiences for and more interactions between merchants and their consumers. This includes increasing awareness of our merchants and the products they sell, enabling others to leverage our terminals, peripherals, and gateways to deliver innovation at the physical, mobile, and online point-of-sale and making the point-of-sale much more secure.

Digital media is a critical capability that enables successful commerce solutions. The ability to effectively target and provide tailored offers from merchants to consumers in real-time at the point-of-purchase creates exciting new opportunities for our clients to grow revenues and see an immediate and direct and measurable return on their ad and marketing dollars. And it’s an opportunity for VeriFone to leverage our substantial consumer facing assets to influence consumer purchasing behavior for the benefit of our clients.

One area we're delivering on this promise today is our global taxi business. In the quarter we moved our digital taxi top products from pilot to expansion in market in New York City. In our first three months, we had eight participating advertisers and sold a 100% of available inventory beyond this exciting new product. Highlights include a really cool program by the way which provided near real-time NCAA tournament score updates on the screens as cabs navigated through New Your City streets. We believe that the potential for our taxi business extends far beyond what we’re seeing today.

Future investments in this commerce enablement platform could unlock scenarios where for example taxi passengers are influenced to go directly to a retailer based on the digital ad that offers a product discount and a rebate on the cab fare that brings him there. Based on the success of our initial launch, we will be expanding the number of tops in New York during Q3 and we will begin expansion into the Las Vegas market and we will be launching a pilot program in London. We will start experimenting with ways of using all of our digital media assets to drive immediate incremental sales for our merchant clients.

Another such area that we continue to invest in is building the scale of our petrol media network. Our innovative in-store upselling platform, which we called LIFT Retail, increased site count by 38% versus the previous quarter and were now installed in over 1,600 locations.

Our petroleum forecourt platform increased active screen count by 24% and is now installed in 4,800 pump screens. Today the screens are enabling scenarios where consumers can be incented at the pump with targeted ads to purchase goods inside the convenient store. Then once in the store consumers receive additional real-time offers. We are seeing increased excitement from our retail partners around both solutions and we are going to continue to invest to scale this network.

As you can see we continue to make progress on our path towards becoming our clients most trusted provider of secure terminals, payment-as-a-service and commerce enablement solutions. We have more work to do and more investments to make, but I am really pleased with our progress in executing our strategic plan.

I will now turn the call over to Marc. Marc?

Marc Rothman

Thank you, Paul. Consistent with the company’s best practice, we will be referring to certain financial statement information on a non-GAAP basis. For the second fiscal quarter, we are very pleased with our results and the progress on our key financial metrics. We reported net revenue of $467 million, exceeding our guidance of $440 million to $445 million. Our net revenues were up 9% from a year ago and up 7% sequentially. Non-GAAP earnings per share were $0.37, also exceeding our guidance of $0.30 to $0.32 per share. This compares to non-GAAP earnings per share last quarter of $0.31 and $0.42 a year ago.

I will now discuss our regional results. Our North American revenues were $125 million compared to $122 million last quarter. Our Q2 sequential improvement reflects several factors. First, our U.S. multi-lane retail business grew sequentially. We continue to see strong demand for our core integrated retail offering, the EMV capable MX 900 series with the number of large rollouts and competitive takeaways during the quarter. Second, our small and medium business unit was also up slightly sequentially. Additional certifications were achieved in Q2 and more are expected in Q3, which should begin to build more momentum with our clients. Third, our taxi business was comparable sequentially.

We continue to see growth in transaction revenues as a result of the continued addition of taxis to our network, but this growth was offset by normal seasonality in advertising revenues. And finally in North America, our U.S. petrol business revenues were down from last quarter as clients deferred purchases as we transition to our EMV capable solutions. Our certification product roadmaps are in line to support the shift and we expect improvement in Q3 and beyond.

Turning to Latin America. Revenues for the second quarter were $83 million, up 22% sequentially, primarily driven by Brazil and Mexico. Brazil was up significantly in Q2 compared to Q1, due to competitive wins with both major acquirers. Q2 shipments from these wins were in excess of what we anticipated and were key drivers to our revenue exceeding guidance.

In Europe, the Middle East, and Africa revenues of a $191 million were up 2% sequentially. We continue to improve in this market and have enhanced our product and service portfolio and continue to see results. We saw strong sales in Spain as a result of completed certifications, enabling market share gains in that country. Sales in the Middle East and Africa were strong, as Nigerian banks expand the cashless society initiatives.

And finally, turning to Asia, Q2 revenues were a record $68 million, up 12% on a sequential basis, driven by strong sales in Australia, where demand was stronger than expected as our clients accelerated their terminal rollouts.

Now let’s discuss results by line of business. Revenues for system solutions were $291 million in Q2, up 4% year-on-year and up 11% sequentially. Service revenues were $176 million in Q2, up 17% year-over-year and comparable on a sequential basis. Service revenues represented 38% of total revenues in Q2. Primary drivers of the year-over-year revenue growth continue to be clients moving to our payment-as-a-service solution, growth in the U.S. taxi market, and our prior year acquisitions in New Zealand and France.

Turning to gross margin performance for these lines of business, our consolidated gross margin was 41.4%, a decrease of 100 basis points from our first quarter. The sequential improvement in our system solutions gross margin from 40.1% to 40.4% of revenue reflects improvement in our supply chain activities, including better inventory management, partially offset by changes in geographic mix, specifically in Brazil, which contributes lower gross margins.

Service gross margin decreased from 45.7% in the first quarter to 43.1% in Q2, as a result of service lines mix, specifically seasonally lower advertising revenues and increased fixed cost investment in ramping our taxi and payment-as-a-service businesses. Consolidated operating expenses during the quarter were $133 million, an increase of $1 million over Q1.

Let’s now discuss our capital structure. At the end of Q2, our cash balance was $230 million and net debt was $710 million, lower by $42 million from Q1. We are very pleased with our progress of reducing our debt by utilizing both our free cash flow and our tax efficient repatriation of offshore cash.

In addition, we had just launched a process to refinance our outstanding obligations. We expect this refinancing to extend the term of our facilities, reduce near-term repayment obligations, improve pricing and provide more flexibility with our various covenants and terms. Subject to market conditions, we expect to close this refinancing in Q3. In addition for Q2, please refer to our maintenance covenant ratio of calculations posted on our IR website for more details on compliance with our credit agreement.

Moving on to more information on the balance sheet and working capital. Accounts receivable balance increased by $38 million to $301 million on higher revenues and our accounts receivable days sales outstanding increased sequentially by 4 days to 58 days. Our inventory decreased sequentially by $8 million to $113 million and inventory measured as days of inventory improved again by 7 days to 39 days.

Accounts payable ended the quarter at $147 million, an increase of $37 million quarter-over-quarter on higher revenues and cost of goods sold and an increase in days payable of 9 days. Our overall cash conversion cycle improved significantly by 12 days sequentially and 29 days year-over-year to 49 days.

Now let me focus on or highlight our working capital as a percentage of revenue, which also improved to 14.3% from 15.7% last year and 20.1% a year ago. We will continue to have a sharp focus on working capital management.

Turning now to cash flow performance, in the second quarter of 2014 cash flow from operations was $57 million and our free cash flow was $36 million, approximately 86% of our non-GAAP net income. Our second quarter capital expenditures were $21 million, including approximately $12 million from revenue-generating assets, mainly equipment supporting our payment-as-a-service and taxi businesses.

Now let me discuss our financial guidance. For Q3, we are guiding non-GAAP revenues in the range of $455 million to $460 million and non-GAAP earnings of $0.33 to $0.34 per share. For the full fiscal year 2014, we are increasing our prior guidance and now expect revenues in the range of $1.825 billion to $1.835 billion and earnings per share of $1.42 to $1.44. Also we continue to expect free cash flow generation for the full year to be approximately 95% of non-GAAP net income, excluding the Q1 legal related settlement payment.

Please refer to our Slide 19 in our earnings presentation for more detail on our guidance as well as additional forward-looking financial information. As Paul discussed earlier, we are continuing the difficult task of looking at every aspect of our business to identify opportunities to reduce overlap and inefficiencies. As a result of this work, we have made a decision to reduce our headcount by approximately 500 FTE by the end of this calendar year.

The expected one time cost of our transformation efforts, including severance related to these activities will be approximately $30 million, of which $20 million will be spent in fiscal year 2014, including approximately $6 million, which was already paid in Q2. The expected annual savings will be at least $35 million. We do intend to use a substantial portion of these savings to fix our foundation and fund our strategic growth initiatives.

In the coming quarters, we will update you on the progress in our 2015 annual guidance. Thank you. And with that, I will now turn the call back over to Paul.

Paul Galant

Thanks Marc. On my first two earnings calls, I outlined the case why VeriFone is a company that really matters in payments. I also laid out the plan for transformation to fix our foundation and to unite us as one VeriFone. And I highlighted our objectives as well as upcoming milestones that would indicate we’re making tangible progress.

There is no question we have a tremendous amount of work to do. But we know from our clients and we know from our employees that we’re making real progress. And we remain committed to driving the changes necessary to become our clients most trusted, most secure and most innovative partner and the first company that they call for terminals, payment-as-a-service and commerce enablement.

At the same time, we’re drafting our next chapter strategy to leverage our global scale, our security and our prominence in the commerce value chain to be the platform that helps merchants drive incremental revenues and precision and measurable returns. I look forward to sharing our continued progress in future conversation.

With that, I’ll ask the operator to please open the call for your questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will come from line of Tien-tsin Huang. Please proceed from JP Morgan.

Tien-tsin Huang - JP Morgan

Great. Thanks. Good afternoon. The slides are really helpful. Let me ask about the cost optimization, I guess, the $35 million in savings? It will be more than what we are thinking initially. I’m curious, the path to getting to the $35 million, I mean, what will it look like as we exit fiscal year, for example? Can you give us some flavor on when you will achieve that $35 million?

Marc Rothman

Thanks, Tien-tsin. This is Marc.

Tien-tsin Huang - JP Morgan

Okay.

Marc Rothman

Let me start with the restructuring, obviously, this is a difficult for us to do here. But as I said, we are in every aspect of the organization, and what I and Paul have spoke to is a 500 net headcount reduction by the end of this calendar year.

The ultimate savings, we believe we will get from that 500 headcount is around $35 million, possibly even a little bit more. What we intend to do in 2015 is to reinvest in terms of fixing the foundation issues, type two or three initiatives, particularly in portfolio management and very much so in R&D.

What I would say in terms of moving ahead to 2015, we have modeled our 2014 to be approximately 29% -- our OpEx is about 29% of sales. And although, we haven’t set the 2015 full guidance yet and I don’t have an absolute number for you on OpEx, what I am thinking about or what we are going to indicate is that, with the leverage of improve sales going into 2015, we believe that OpEx as a percentage of sales should be down by about 100 basis points. But let me be clear, as we execute these headcount reductions, we expect to invest, reinvest a significant amount of savings into the initiatives and the growth platform.

Tien-tsin Huang - JP Morgan

Marc, just to be clear on the reinvesting, that excluding or including the severance that you had laid out and maybe if you can just give a little bit more detail on the reinvesting, I mean, are we talking about hiring some people after the 500 folks, are we talking about buying some software or licenses are bringing some consultants to do the work? Just try to give a better understanding of what significant might mean mathematically? Thanks.

Marc Rothman

Sure. From a reinvestment standpoint, I would view it as more of a variable cost. We will be looking at outside services, contract labor, there maybe some incremental hires at the end of the day as well and all the above like you mentioned.

Like I mentioned as well, Paul and I will be in a better position as we progress into Q3 and Q4 to provide more information and the next savings going into 2015. But for now, given that it’s early days, we have an intention to indicate that it’s going to be reinvested -- substantially reinvested.

Paul Galant

I would just add a little bit to what, Marc said, when we are going from 13 operating systems to one. That is a software endeavor, obviously. And it involves a lot of integration work with clients that already have applications that they have written on one of the 13 operating systems that might be going away. And so middle layers, translation services, all of those things. They are not always people that you have in seats today that are expert to this kind of work and yet you need that level of expertise.

So we are going to be positioning the type of skill set that we need for a period of time. I agree with Marc, when we can, we will use contract labor, because they distinct thing that need to get done, we want to go from 13 to one. And then we want to start building on that one and making available on that one the future of application development and in that case you probably going to have a larger group of software experts and know how to do commerce enablement type of solutions, not core payment type of solutions, which we want traditionally on terminals so that we can accept cards, right. So, a little bit of a shift in resource and talent.

Tien-tsin Huang - JP Morgan

Got it. Yeah. We can work with that, because it sound like some of that will be temporarily labor to work through it. Okay. I appreciate that.

Paul Galant

Thank you, Tien-tsin.

Marc Rothman

Thanks.

Operator

Your next question will come from the line of Jason Kupferberg from Jefferies. Please proceed.

Jason Kupferberg - Jefferies

Yeah. Thank guys. Congrats on the continued progress. Just a question on the outlook here, so it looks like the guidance calls for revenue and EPS to be lower in the third quarter versus the second quarter? So I’m just wondering if that’s a function of some pull-forward of revenue in Q2, which you kind of eluded too?

And then along those same lines, if I have my math, it looks like the full year revenue guidance is being raised by something more than the amount of the beat this quarter in Q2 or you are raising the EPS guidance, I believe by a little last than the amount of the Q2 beat? So any comments on that as well would be great?

Marc Rothman

Yeah. Thank you, Jason. Thanks for the compliments on the quarter as well. We will take it. We appreciate it. With respect to Q3, it’s down slightly from the $467 that we printed for Q2. So we are guiding the $455 to $460.

Two things going on there, one is that, we did have accelerated sales to customers in Australia, that was part of the benefit or the unplanned increase in Q2 and we expect that to have an impact our Q3 sales. So Asia in particular we are estimating to be down sequentially from Q2.

North America, just to give a little bit more regional color, I think will be up slightly, with the continued momentum we spoke about. Latin America for planning purposes, we had a great quarter actually in Brazil. It was the best quarter we've had in the last two years in the Brazil marketplace and we’re planning for Q3 to be at -- to be down slightly. So just to be succinct it was be another good quarter, better than we had initially planned. But it’s down from Q2 given the color that I just provided.

And for the full year 2014, it's substantially higher than what we had guided to last period. Certainly recognizing the revenues that we beat by in Q2 and in terms of the $1.40 per share that we’ve guided to the $1.40 to $1.44 is reflective of the $0.05 or $0.06 beat but also the takedown in earnings per share for Q3 that I just discussed.

Jason Kupferberg - Jefferies

Okay. Understood. And then can you just give us the latest summary of where you are at with remaining product certification on your roadmap here? I know you mentioned a couple of more forthcoming in U.S. SMB and I'm assuming that the next-gen product in Brazil is still on track for your Q4? So if you can just catch-up there that would be great?

Marc Rothman

Yeah. I think everything is on track. So all the items that we discuss to do in the last two quarters, obviously, we are making a lot of progress, it’s a function of focusing our resources to make sure that these client demands are met. And so we get up every morning saying, on time, every time with high quality and that’s what we got to do. So a lot of folks are toiling away to get that done.

The things that are left for Q3, we did in the priority order. We wanted obviously certified terminals that our largest, most critical clients have been patiently waiting for, got that done and have now started to focus on areas that you know, like the SMB space where we have a lot of opportunity but we just tell we didn't have the resources to do everything at the same time. So we’ll be continuing to do that for the balance of the year.

Everything is on track, everything is on plan. In some cases, we're doing it early. Certainly in the case of Brazil like, we’re happy to see that the team is making progress a little bit ahead of plan.

Doug Reed

Thank you, Jason.

Operator

Your next question will come from the line of Gil Luria from Wedbush Securities. Please proceed.

Gil Luria - Wedbush Securities

Yes, thanks for taking my question. When you had with large retails of 15 plus the six competitive takeaways, how much of that’s been rolled out. What’s the timeframe for rolling out? I'm assuming these are the bigger retailers with the larger number of terminals to roll out. How long is that process going to be in and how much of that was sense of urgency around EMV versus normal upgrade cycle?

Paul Galant

Well, let me take that. I think Marc’s got more detail on it because I have been speaking to a lot of clients. There is absolutely a sense of urgency to peel the onion on how secure the point-of-sale environment is at all these brands. It’s top of mind. It’s what their CIOs wake up worrying about. It’s what their boards are asking the fields about. So there is tremendous activity. They are walking around with clipboards and they are really getting to the details.

As I mentioned, we are fortunate to be getting the first call. We’re at the white board with them, discussing it and they are not kicking the can down the road as perhaps some of them were a year ago. So today if they are able to put in a new terminal -- a new terminal solution, they do. They're not putting it in purely for EMV purposes because it’s -- they earned a lot of EMV cards out there.

They are putting it as part of a comprehensive redo where they are doing encryption on an end-to-end basis, where they are talking about securing their website and making sure that none of their customer data is ever in the clear. So it is -- EMV terminals is the way we articulate the fact that they've done something but it's not really because they want an EMV terminal a year before cards are going to be out or any time before the liability shift data solidified. It's really because it's part of upgrading the security of their environment and they are not waiting to do that.

Marc Rothman

Hey, Gil. This is Marc, let me just give a little color on your question on timing. There's diversity in terms of the timing of the rollouts in general. What I could add is that the order input is absolutely better than it's been over the last 12 quarters and it aligns with what we’ve talked about. Well, Paul has just mentioned in terms of front and center, top of mind relative to the liability shift. So the momentum in the retail business in North America is excellent.

Gil Luria - Wedbush Securities

Got it. And as a follow up on your cost optimization, you talked about taking out the 500 of employees by the end of this year. But in terms of the facilities and the consolidating of the SKUs and the legal entities, what’s the timeline for getting those done?

Paul Galant

We’ll make some progress on all those this year. In fact, we've made some progress through the first -- for the first half, covered number of facilities that we’ll be exiting 10 or so by the end of this year. Legal entities, we have 130 plus we’ll be out of 19 or so by the end of this year.

So it’s all hands on deck in terms of optimizing the end-to-end cost structure. With Paul, I did today was give some color on some specifics. But this is -- this is as you can imagine multi-year assets and it’s not only a function of driving cost out of the system for which activities will certainly do, but it also helps to remove some of the complexity across this organization.

Paul Galant

One thing I would just like to add is as you consolidate from 13 operating systems to one, and as you reduce hardware products SKUs significantly and you standardize on chassis, which have almost everything in common irrespective of where they are deployed, you can create a lot of change in how quickly you can get your things certified. Today when we have to do certifications we’re having to manage it on 13 operating systems, which is why I say sometimes we just don't have the resources to do the certifications across all those. When you get to one, it’s much more predictable that you can get your stuff certified in markets. So this is a data driven exercise that VeriFone is going through. Everything is prioritized. There is a pretty disciplined process for execution and we will continue to report progress I wish with instant, but it's not. It just takes a long time to do this right and do not have your clients have their business impacted. So, that’s what we’re doing.

Gil Luria - Wedbush Securities

Thank you.

Operator

Your next question will come from the line of Bryan Keane from Deutsche Bank. Please proceed.

Bryan Keane - Deutsche Bank

Hi, guys. Thanks for taking my questions. On the executing of the top three VeriFone initiatives; the product portfolio management, R&D reengineering, and the cost optimization. I guess two-part question. Just one clarification on that, is that the all three of those totaled the 35 million, or is it just the cost optimization piece? And then secondly, is there a revenue impact at all from these initiatives?

Marc Rothman

On the first part of your question, the $35 million savings to be reinvested goes across all three initiatives.

Paul Galant

In terms of the second part of your questions on revenue, the reason why we have Master PowerPoint and have done a lot planning was because we wanted to avoid the revenue going away. So as we make these plans, there's a lot of dialogue with each client, that's impacted by a product going away and we’re providing for that client alternative solutions. In most instances, the solutions do more than the item that is going away and provide some better set of functionality. Thus far in the cases we presented to our clients, they have kind of -- I guess they are wondering what took us so long. So they really like what we’re showing them in place of what they have and we’re making it easy for them to say yes. And so we're not expecting a lot of revenue leakage through this process, there might be some, but it's really that we haven’t seen much of it today anyway.

Bryan Keane - Deutsche Bank

Okay, super. And just last question on gross margins, Marc, can you talk a little bit about mix, can you talk about what gross margins what we can expect kind of going forward as the model revolves here? Thanks so much.

Marc Rothman

Thank you, Bryan. I gave a pretty good color I thought in the presentation on Q2. But to be specific to your question going forward for Q3 and Q4, we expected to be relatively consistent in Q3 and as we get into Q4 with improvements in both revenue and leverage, particularly on the supply chain side, I expect the revenues to tick up slightly revenues to gross margin tick up slightly in the fourth quarter. And then as we get into 2015, we will provide more color. But clearly getting more leverage out of the supply chain and removing the complexity is where we hope to capitalize on. Appreciate the question. Thank you.

Operator

The next question will come from the line of Phil Stiller from Citi. Please proceed.

Phil Stiller - Citi

Hi, guys. Thanks for taking my question. First, I guess I wanted to focus on the payment-as-a-service business. Can you give us the growth rate in the quarter, and I guess how materially you think some of these new markets can be over the next year or so?

Paul Galant

Well, Mark is trying to find the growth of payments-as-a-service in the quarter. I can tell you that we are going through sort of a three-step process with our payment-as-a-service business. One is we have this Nordics business called Point and when you peel the onion on that business, you realize that in some part, it grew out of their own acquisitions. And so, we do have somewhat different types of payment-as-a-service approaches, some different types of software that can do the same sort of thing. And so we are homogenizing and trying to get to the best-of-breed across all the Nordic markets.

The second is to take our non-Nordic payment-as-a-service businesses, many of which grew up independent of Point and trying to figure out what elements of the excellent work that the folks at Point have done would improve those businesses, places like Israel, places like Mexico, so forth and so on. And as you know, we have some new markets, Australia, New Zealand and we're trying to get to a global model.

The area around new markets, interestingly enough, there was never a global approach to payment-as-a-service. So when I came in, I expected to see a heat map like our stack ranking of the next best market for us to go into is this or not, it wasn’t there. And it wasn’t there because we really never product management, managed this area. It’s now being product managed, it’s now being run globally and we now have a heat map of countries.

And the markets that we have launched next, may not be the biggest markets but they have the highest probability of creating value for the clients that we serve that want to do that sort of thing in those markets, right. So, obviously, the U.S. is the largest market and although, we are working in the U.S., it wouldn’t probably be the first place that we would try to do a lot of payment-as-a-service work because there are other markets where there is real pent-up demand. It’s a little bit of an easier process for us. And so not a straight answer, but I just want you to understand the framework and approach that we take to this. Mark?

Marc Rothman

And just, thanks as well on the question. Just on payment-as-a-service, the total services business was $176 million, so is comparable to the prior period. In that I had mentioned that the advertising revenues were down sequentially and the other side of the equation was payment-as-a-service up slightly.

Phil Stiller - Citi

Okay. That's helpful. And then switching gears, the cash flow conversion you guys have made a lot of progress on that over the last year or so. Is that something that you think is at a sustainable level or can further improve from here? What are the expectations as we move forward?

Paul Galant

So we are happy about the continued improvement at working capital and driving the net amount down in cash conversion cycle to be 49, and it hasn’t been there in a very long time, probably 10 years for VeriFone. I think it's about where it belongs. It’s going to ebb and flow, it could go up a few days. It could go down a few days depending upon geographic mix on receivables in particular.

I am pretty comfortable relative to the growth rates that we are assuming in our outlook that the working capital targets where we are today are probably, where we will be for a while. It was an incremental improvement. It is going to be a little bit more challenging but our goal is to keep it around where we are today.

Phil Stiller - Citi

Okay. Thank you.

Paul Galant

Thank you.

Operator

Your next question will come from the line of Mike Grondahl from Piper Jaffray. Please proceed.

Dain Haukos - Piper Jaffray

Hi guys. It's Dain on for Mike. I just had a question, after going through the -- just kind of really big transformation in R&D functional all that. I was just curious if you could highlight maybe some of the checks and balances that you’re going to starting to make sure that in future, you don't have an issue with certification related and that kind of things. Are you guys probably looking for that relatively speaking?

Paul Galant

Yeah. I’m happy to take that. I’ve been spending a lot of time with our R&D, had a look to notes and our three global product managers in the case terminal and certification it is Bill Nelson who runs terminal solutions for us globally. The first thing is visibility and transparency and the fact is that right now, I am able to look at a dashboard that shows me where we are across all the product lines, where we are in certifications.

It is a weekly cadence that we review where we are in all that. And we are not trying to beg, borrow and steal resources from one country to another to get the stuff done. So it’s much more planned, much more anticipated, much more data-driven, much more stack ranking our priorities. And very, very good feedback mechanism like, lumpy business reviews, weekly transformation meetings, weekly management meetings, lots and lots of transparency on scorecards.

And Bill Nelson has in his scorecard, making sure that all the terminals that we have in the plan are certified on time and that they have high quality and everyone has the same thing. So, I think we’re putting good checks and balances, obviously, they can always be better. And I think in this case, we’re better by virtue of how long we road test them and how we adjust them over the period of time. But I still feel like we've got good (indiscernible) suspenders today.

Dain Haukos - Piper Jaffray

Okay. And it looks like too, you said it actually reduced even more of those SKUs from, call it first quarter to this quarter. So, I think before you had said 250 and now you’re going to -- it looks like you are going to reduce even double that number, is that correct?

Paul Galant

Yeah. That’s right. What I want to do is I want to give you all the transparency of what we learn as we go through our process. And thus far our hypotheses have turned out to be right, but dimensions of the numbers, we are starting to see a better result. Part of why we’re little nervous because we just didn’t know how the client side was going to react.

And given the fact, there is so much concern around security, there is so much concern around updating and making sure people are best-in-class. When you go to someone that has an old terminal and you say, hey, we’d like to replace it with the new terminal and it has the following benefits, they’re inclined to do that. And so because of that, we've been able to be a little bit more comfortable in pushing to reduce product SKUs. So that's the way it’s going to continue.

Marc Rothman

And Dain just to add a little bit color. Also part of the benefit that we had in this update was the sun-setting of certain products that were under the PCI 1.3 standard. So as those products, if you will sunset or sunset it on April 30th and also was helpful in SKU reduction and eliminating some of the VeriFone complexity.

Dain Haukos - Piper Jaffray

Okay. Great. Thank you very much.

Paul Galant

Thank you.

Marc Rothman

Thanks, Dain.

Operator

All right. Ladies and gentlemen, we have time for one more question and that question will come from the line of Andrew Jeffrey from SunTrust. Please proceed.

Andrew Jeffrey - SunTrust

Hey, guys. Thanks for taking the question. You make me dig down a little bit in the pile here. It’s nice to see Latin America really shift over Brazil in particular. Could you kind of give us a sense of how share shifted pretty far away from VeriFone during the dark days, and how far, how close are we to equilibrium now and how much more is there to go in Latin America in terms of share shift among those two big customers down there, Brazil, I guess, in particular?

Paul Galant

Yeah. Happy to take that question, Andrew. Latin America is important, as well as super important given the fact that, it’s got two of our biggest customers in the world. I think that there is -- there are two answers to your question. One is, there is a relationship angle here.

The fact is we did not invest in the relationship with these folks. I think we didn't do a good job of listening to them and understanding their priorities. I think we made decisions without engaging them on product, on price, on timing.

And I don't know of a single client who is going to be happy doing business with some one that doesn’t listen. It doesn’t matter what price you give. If you don't listen and you're not willing to be a partner to help them build their business to succeed, they are not going to engage with you. So don't underestimate how messed up that was, because I think it was pretty messed up.

The second was, we -- as you know, I think, there was a period time where VeriFone was managed as a stock and not as a company, those are my words and decisions were made to not spend money to show terrific earnings and in not spending that money, we didn't do what we needed to do to have product ready, certified.

It is a very intense process as you know to certify a product and you need to have the right people, you need to have the right investments. But if you pull that back, you don’t have an immediate hit, you got a hit couple of quarters down and that’s what happened to us.

So we're not going to kick cans down the road. We are not going to cutoff nose despite -- we are going to manage this as a company for the benefit of its clients and in doing that we will be ready with the products that they need because we will listen to them, we will prioritize them and we would been upfront. No saying we are going to it and they are not showing up. Just discipline and just a different, I think maybe more mature way to run this business.

Andrew Jeffrey - SunTrust

Though, it sounds like, perhaps your, there's more room to go, I guess, in terms of repairing the relationship hence the ability to drive revenue growth? I am just trying to understand because you had a big sequential uptick in things like you fixed a lot of the share issues there, but it feels like there is perhaps additional…

Paul Galant

Yeah.

Andrew Jeffrey - SunTrust

… is that the right way to think about it?

Paul Galant

We fix the relationship before we fix the product. So we realize that we were not doing a good job being a good partner for this client. So we stepped in very early in the process, spent a lot of time with these clients and so that what’s happening before we have product to sell them.

As the product became available, they decided to do business with us and give us another shot and we've done nicely, thank goodness we've been able to capture most of the share back, there's probably a little bit of upside, I would say. But I think it could be lumpy, I think we can have one good quarter, one less good quarter.

But, certainly, back in full consideration and let the product quality and solutions and services now be the factor that causes us to win share not self-inflected rules causing us to loose share. We want to win based on the fact that we have the best product and have a great relationship with the client and I think we are now poised to at least have that as an opportunity.

Andrew Jeffrey - SunTrust

Okay. And I know there are lots of moving parts in gross margin market, sounds like Brazil might have been the single biggest sort of headwind to product gross margin was up sequentially, all else being equal, do you think your product gross margin continues to expand, how much, we can think about mix, how much is mix influence gross margin over the next couple of quarters as…

Marc Rothman

Thanks. So on gross margin, the mix absolutely was the single biggest challenge in terms of the Q2 results and the margin, the mix obviously will play clear role or impact the results in the rest of this year as well.

I think we are doing a lot of good things in terms of the supply chain. There is lot of optimization efforts underway. The inventory levels coming down from $189 million, a little bit more than a year ago to $113 million has certainly not -- we certainly cleaned out a lot of the challenge that we've had over the past few quarters. So, I'm looking forward to improvements in general. But clearly mix is going to have an impact.

And then I also just not leave you hanging, but on the services side it’s the same thing, advertising revenues on the fixed cost platform as they go up or down, that upward obviously, be helpful to the margins but as they move around, it could have the opposite effects.

So what we are trying to do and I am trying to do here, Andrew, just give enough color in our guidance to give you net direction in terms of where we think the margin is going to be. As I mentioned earlier to, Brian, I think, Q3 will be relatively flat to where we were in Q2 and then there is an opportunity for some enhancement in Q4.

Andrew Jeffrey - SunTrust

Okay. And I assume some of that enhancement Q4 probably reflects the revenue generating capabilities of some of the services investments with taxicab, et cetera this quarter.

Marc Rothman

That’s correct.

Andrew Jeffrey - SunTrust

Okay. Great. Thank you.

Paul Galant

Thanks very much, Andrew. This is Paul. Hey, folks, I just want to say thank you very much on behalf of the VeriFone team. We are doing our level best here. We are working hard and we appreciate all of the coverage and all of the thoughtful questions. We will be back to you in future quarters and we will be telling the story. Thank you.

Operator

Ladies and gentlemen that will conclude today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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